Schroders’ Le Jéhan: Taking stock during the summer lull

The summer lull always provides a useful time to take stock. Investing is never straightforward, but right now we find ourselves somewhat conflicted by improving economic data alongside markets revisiting highs post the wobbles of May’s ‘taper tantrum.’

As we’ve noted for some months now, there are tentative signs of improving conditions both in the US and across Europe. But, somewhat disconcertingly for us, many investors appear ready to move seamlessly from the ‘free lunch’ of the quantitative easing years to the nirvana of a sustainable economic recovery and the buoyant markets that this ‘should’ engender.

To us, this seems a stretch. Of course, improving macroeconomic conditions are helpful, not least in boosting confidence, itself a driver of near-term markets as Oaktree’s Howard Marks noted in his excellent recent memo. But ultimately, valuations drive longer-term returns. The withdrawal of stimulus and the tightening of government belts that must occur at some stage will inevitably have an impact on the willingness of investors to pay such high prices.

We, like many, have benefitted handsomely from taking on a degree of risk as markets re-priced in recent years. But, across the board, major markets no longer look as attractive as they once did. The boon of an economic recovery – albeit one of the most muted on record – is something to be welcomed, but still with a degree of selectivity at the heart of our portfolios.

And so it is that we arrive in to August with what, to the casual observer, look deceptively like defensive portfolios – a blend of selective equities, minimal fixed interest and still relatively high cash levels.

We remain guided by the mantra of taking risk where you’re being paid to take such risk. So our ‘defensiveness’ relates to a lack of attractive valuations rather than a broader dislike of economic conditions or any outlook at this stage. History has taught us that buying expensive assets has never improved one’s wealth over the longer term.

With peak margins, muted earnings guidance and ever higher valuations large portions of equity markets – particularly those areas of perceived defensive quality – remain at risk in our eyes. Likewise, the end of a 30-year bull market in sovereign debt does not scream value to us from here.

This is a market recovery that few have truly believed in led, in part, by bonds and bond proxies – that have yet to significantly reverse as macro conditions have improved in recent months. A sustainable recovery, and the normalised yields this could entail, should eventually dampen the exhaustive ‘hunt for income’ that has for so long been prevalent.

Indeed, a more widely accepted upturn could warrant further shifts into areas of more cyclical value in equity markets that have rallied still somewhat under the radar to date and still offer decent opportunities. Our continued emphasis in these areas of perceived risk – particularly in the still relatively under-loved areas of Europe – balances a cash holding highlighting that markets have travelled a long way in a short space of time.

Rising markets, where most areas have worked, tend to put investors at ease and the degree of complacency as evidenced by still suppressed volatility warrants wider caution in our eyes as we wait for a better entry point. The last 18 months have provided ample opportunity to take risk.

But as markets continue to reach new highs and adjust to the changing macroeconomic environment, we’re conscious not to simply accept all risk. Selectivity, and an appreciation that the winners of the last cycle aren’t necessarily the winners of the next, remains key.